Derivatives might not keep Warren Buffett up late at night, but he is concerned about them. The problem, he says, is that no one knows how to value them properly.
The Oracle of Omaha is famous for calling derivatives "weapons of mass financial destruction." The fact that his Berkshire Hathaway has substantial holdings of these financial instruments tends to illicit at least one critical question at the annual shareholder meeting. This year was no exception.
When asked about the problems with derivatives, he cited 9/11 as an example. After the terror attacks razed the Twin Towers in New York City, financial markets closed for several days. When they reopened, prices of securities and derivatives had moved substantially. Buffett calls this problem one of "discontinuity."
“If you have a major cyber or nuclear or biological attack on the country—a major discontinuity—you have a lot of problems…When you open back up, you can have large gaps in the positions," said Buffett. He added that such a situation was a "potential time bomb."
But derivatives are essential to any large corporation in its day-to-day operations. Buffett's criticism was aimed mostly at the purely speculative bonds and derivatives that were instrumental in causing the financial crisis.
Buffett raised a serious issue with respect to valuing these esoteric financial instruments. When companies are audited, the accountants assign a dollar value that is supposed to reflect the company's exposure.
Buffett said he knows at least one case where two companies were represented by the same auditor and had a derivatives contract with each other. Shockingly, the auditor assigned different valuations for the same derivative. He said doing the math on that would be an "interesting exercise."
Buffett finished his answer by dropping a scintillating nugget about one position in particular. He said, "I know one [derivative] that’s so mismarked it would blow your mind."
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